––– a weblog focusing on fixed income financial markets, and disconnects within them

Thursday, January 12, 2012

A Fair (Value) Solution

Hello readers, and a belated welcome to 2012!

In yesterday's FT Citigroup CEO Vikram Pandit advocates for heightened transparency across the banking system, enabling an apples to apples comparison that “[clears] some of the obscurity that causes people to believe the system is a game rigged against their interests.”

He is not alone. Late last year, Barclays' Group Finance Director Chris Lucas called for greater transparency in the financial reporting of liability valuations. The concept, of course, is that transparency is desired by investors, once bitten, before they can again get comfortable investing in banks.

Pandit proposes a solution that involves creating a benchmark portfolio against which banks can measure their relative risk.

Asset valuation itself has become the number one concern for the SEC in 2011: through mid-December the SEC had, according to the WSJ, issued a total of 874 “comment” letters to 802 distinct companies concerning their fair valuation and estimation of assets and contracts. Meanwhile, audit firms PwC, KPMG, Deloitte and others have been criticized as to their oversight of their clients' valuations and valuation processes (see Contested Pricing List). And so it is not surprising that banks are trying to overcome these substantial hurdles, though understandably in ways that suit them best.

The problem here is akin to the one faced by technology companies: the evaluation of their patent portfolios is no mean feat and is highly subjective – yet it is a crucial component of their stock price, especially in an acquisition or dismantling process.

Pandit’s solution is one solution. Another is more arduous, but overcomes the dual problems of inconsistency and subjectivity. It also combats the material regulatory arbitrage gaming business that has been created to minimize capital reserves. We would be able to say good-bye to a whole business of utility-free resecuritizations, structured solely to game the ratings models to achieve, or manufacture, lower reserves. It would be the end of certain Re-REMICs and perhaps even AAA-rated principal protected notes.

The solution, of course, is to evaluate each and every bond. This is already being done (to an extent) by the NAIC, and would add stability and assurance to our investor base.

Asset valuation may be more art than science, especially in the world of illiquid assets – but at least it's not a game. If well-performed, it can provide the cross-company valuation consistency even our bankers are calling for.

2 comments:

Measuring that risk is a critical part of understanding the potential for the bank to encounter difficulties or perform well. Often called mark-to-market, measuring the fair value of financial assets and liabilities is an essential step when analyzing the fundamentals of a financial institution.